Preparing for a Recession

I don't know if a recession is coming. Nobody does. We may dodge the bullet for a while. On the other hand, the economy may already be in recession. You don't need to know the future, though, to make some wise moves.

Recessions hit everybody differently, so we'll take a look at how things tend to play out for people in different situations. First, though, it helps to understand what a recession is. (See also: The Recession Glossary)

What Happens in a Recession

A recession is a reduction in the total amount of business done in the economy.

When conditions are right for a recession almost anything can set one off — anything that prompts businesses to decide to produce less, or prompts consumers to decide to buy less. High oil prices, for example, may lead consumers to cut back on food and clothing purchases so they can afford enough gasoline to get to their job. A credit squeeze may force businesses to scale back, because they can't borrow enough to buy all the raw materials they need to keep their factories running at full capacity.

Once a recession gets started, it tends to spread. Every business that sells less also buys less — meaning their suppliers are doing less business. Pretty soon, all those businesses are laying off employees — meaning a bunch of would-be consumers no longer have any income, so they're buying less as well.

How It Affects You

A slowdown in business hits you directly if you own a business. It hits you one step removed if you work for a business (or want to) — jobs will be harder to find, raises will be smaller, layoffs will be more common.

A lot of people don't work for a business. Some work for governments (federal, state, local). Others work for institutions, large and small: colleges, universities, hospitals, orchestras, art centers, food pantries, land trusts (any of which may be purely independent or government-sponsored to some extent). People who work for governments or institutions are a second step removed from the impact of a recession, but that doesn't make them immune. The decline in business activity always reduces tax receipts to governments, leading to cutbacks especially at the state and local level. A general decline in prosperity often reduces charitable donations, leading to cutbacks at private institutions. Again: fewer jobs, less secure jobs, smaller raises.

There are also, of course, people who don't work in the money economy. Putting aside children and non-working spouses (who face the same circumstance as their family breadwinner), I divide these people into two groups — the ones who are actually out of the money economy (subsistence farmers, freegans, prisoners), and the ones who are are in the money economy but their income doesn't depend on the work they do (the wealthy, retirees, people on welfare).

It's an important distinction, because people in the second category are depending on promises — the income from investments, pensions, social security, welfare, and the like — which are at best only as sound as the finances of whoever is paying the money. In a recession, that soundness is threatened.

If you live on promises, remember that promises get broken — especially in a recession.

What to Do

So, what can you do to soften the blow if a recession hits?

Reduce Your Expenses

The first key, whether your income is tied to a business or not, is to reduce fixed expenses. High variable expenses can be tolerated, as long as there's an income stream to pay them. But high fixed expenses will wreck your finances very quickly if the income stream dries up. This means reducing debt and avoid new obligations (fitness center memberships, burglar alarm contracts, etc.). For businesses, it means postponing hiring (hire temps instead) and postponing raises (instead, offer bonuses conditioned on profits).

Increase Your Emergency Fund

The second key is to boost your emergency fund. A temporary income shortfall doesn't need to become a financial catastrophe, as long as you have enough cash on hand to tide yourself over. Resist the temptation to rely on credit as your emergency fund. It can be tempting to figure that paying down revolving debt frees up part of your credit line for use in a future emergency, but that's not the same as an emergency fund. At any time, but especially during a recession, lenders can cut credit limits, refuse to extend further credit, or simply get out of the business entirely. Have an emergency fund that doesn't depend on someone making you a loan. (After all, the classic reason to tap an emergency fund is when you've just lost your job — which is exactly the time that a creditor would be especially likely to cut off your credit.)

Diversify Your Income

The third key is to diversify your income sources. If your goal were maximum total income, diversity would probably be the wrong choice. There's almost certainly one income stream that would give you the highest total income if you put all your effort there. The problem is, that's not a stable strategy. A better choice, especially if a recession is in the offing, is to try to arrange several income streams, some of which don't depend too much on a thriving economy.

Reduce Your Dependence on Money

The fourth key is to reduce your dependence on money economy. This is the one sure way to protect your family from recession — provide for their needs without having to spend money. It seems unnatural in today's world for people to grow their own food and make their own clothes, but, to the extent that you can do so, you're in a position to just ignore the ups and downs in the economy. All the other options are just stop-gaps — they help you keep things together until the economy picks up again. This one actually solves the problem.

Same Strategies, Different Balance

Wise Bread readers will recognize these four strategies as the same core principles that we talk about all the time, so I'm not telling you to do something new. Rather, I'm suggesting that you alter the balance. The downside of all these strategies is that in good economic times they result in a lower standard of living than you could achieve if you followed more mainstream personal finance strategies. In bad economic times, though, these are the winning strategies.

In good economic times, a business that refuses to use debt to grow will inevitably fall behind its more aggressive competitors. In bad economic times, the business that avoids debt will survive while the others will fail. For individuals, the calculation leans even more away from debt.

On top of that, a recession provides many opportunities for someone with ready cash. When no one else is buying, someone with cash in hand can get some terrific bargains — enough to catch up with years' worth of "lost opportunities" for growth.

We don't know for sure that bad economic times are coming, but the threats to the economy (housing collapse, credit crunch, spiking prices for oil and food) are as great as they've been in a long time, and the potential missed opportunities from an excess of caution are smaller than during a boom.

Now is the time to go with these strategies — accepting the slower growth and lower standards of living that go along with them as a small price to pay for security and a reasonable shot at some big opportunities ahead.

Remember, a recession is a time when promises get broken. Business fail, leaving both their debts and their employees unpaid. Tenants don't pay their rent. People who have always paid their bills on time suddenly can't. Sales fall through. Wherever your income comes from, it is at some risk. Arrange things so that you can face that risk.

Update: The National Bureau of Economic Research, the group that makes the "official" call on the beginnings and ends of recessions, announced on December 1st, 2008 that a recession began in the US in December 2007, the month this post was written.

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I think this is a really helpful post Philip. What would you suggest in regards to investments in times of recession? Leave them alone? Move into more conservative funds? Not check your 401(k) account three times a week while stocks continue to fall? I'm curious as to what your thoughts are to the emotional side of preparing for a recession.

Although it's tempting to try to time the market--pull funds out of stocks in anticipation of a downturn--it rarely works out for the best. The reason is that upturns in the market can happen so quickly. I've seen studies where having your funds out of the market on the 1% of the days with the biggest gains could cost you most of the market's total return. (Of course your plan would be to be back in the market for those days, but how would you know?)

My advice is to start with a good, big emergency fund--big enough to handle an extended period of unemployment, with enough money to cover your planned major expenses. Once you've got that covered, determine an appropriate asset allocation--one rule of thumb is to calculate the stock portion of your investment portfolio by subtracting your age from 100, so a 25-year-old would put 75% of his or her investments in stocks. Then go ahead and take the plunge.

Remember that a falling market is a great time to buy--you're getting the stocks on sale. (Obviously a fallen market is even better, but nobody can reliably know when it's hit bottom.)

Right now is probably a great time for someone with only a small investment portfolio to start moving more heavily into the market, as long as you remember that your investment horizon is decades.

My problem is that the money is losing its value and I do not understand why should I save money during inflation. I may not be able to buy anything from my savings tomorrow?
How can I save money and make sure that I will receive enough return on it to cover inflation?

There are an awful lot of economists. As a group they're terrible when it comes to making economic predictions, especially about the future. In fact, they can't even be counted on to make accurate predictions about the present. They are, however, pretty good at analyzing the past.

The National Bureau of Economic Research is generally accepted as the authority on when recessions begin and end. They date recessions from the peak to the trough of economic activity, and then date the expansion from the trough to the next peak. The last trough was in November of 2001, so we've been in an expansion since then.

The thing is, though, it's always months after growth ends before the peak that marks the end of the expansion is evident. (They didn't call the March 2001 peak until November 2001--the same month the recession ended.)

So, yes, we've been in a period of growth since then. But a recession may have started already--we wouldn't know about it for a while yet.

"We" are not in a recession, but that's the national "we", not the community "we" or the family "we". There is definitely a recession, even a depression in the housing sector in the big cities - prices are down, and sales volume is down. On the other hand, in the manufacturing exports sectors, we're probably growing, because the dollar's not worth so much today. The happiest person will be the person who can move from one sector to the other, or the construction company that happens to also build or renovate factories. :-)

The 50 year old builder with a mortgage isn't going to be very happy.

The people with the least, who work in the worst jobs for the lowest wages, who can't save up for a potential recession because they not only live paycheck-to-paycheck, but already live frugally, suffer first.

The purpose of an emergency fund is to allow you to adjust to changed circumstances in the case of an emergency.

Often an emergency fund will also make a little money, in the form of interest. Other times, the interest earned won't be quite enough to keep up with inflation, meaning that you fall a little behind. But the goal is not the little bit of interest that's earned. The goal is the protection that comes from having some ready cash. Even if you have to pay a little for that protection, if you need it, it's well worth the small cost.